Bear Mountain Bull

From Mr. Practical today:

The Fed has a potpourri of risky assets they’re willing to accept in exchange for capital. Because banks have no capital of their own, they can’t decide to extend credit on any asset not on the Fed’s list of acceptable collateral.

This brings us to convertible bonds. Corporations have used convertible bonds to raise money over the last 10 years, to the tune of $1 trillion. It has therefore been one of the most important capital-formation asset classes in the world.

Without getting too complicated, corporations exchange a lower interest rate as a cost of funds for a call option on their stock. The whole thing works because hedge funds have been able to pay a higher price for the convertibles, because they can hedge the risk by selling stock short. This requires just a modicum of leverage – about 2 or 4 times.

The companies are happy, because they can raise money at a good cost of capital. The hedge funds are happy because they can earn a reasonable return for a fair risk. There was liquidity in the system.

When the Fed decides to take certain risky assets as collateral and not others, the other assets become worthless as collateral to a Broker/Dealer that’s lending money to hedge funds. As BDs deleverage (not a bad thing), it’s important they do so in a balanced way. Because convertible bonds aren’t accepted as collateral by the Fed, BDs can’t use them as collateral. They therefore suddenly called up hedge funds and demanded full cash (no leverage) overnight.

This created one of the biggest sell-offs in history, as hedge funds were forced to sell convertible bonds at any price in order to raise the cash demanded by their prime brokers. They had no choice in the matter. Large hedge funds in business for 15 years or more went out of business overnight.

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I use this example to show the world the nature of government intervention: That it does much more harm than good, because it operates from imperfect information and non-economic motivation. They try to “fix” one thing, and another breaks. The government has ruined a very important asset class by trying to fix completely broken ones that use much more leverage.